Development of an individual economy passes through different economic phases. Sometimes it is booming and sometimes it suffers from recession. This phenomenon can be viewed as projection of consumption and investment strategies of the individuals and the government of the country. Interest rate, being a major factor of economics, plays a great role in economic activities carried out by nation and the nationalities. A change in interest rates may affect other factors of the economy. For instance, investment strategies of the investors, consumption strategies of the individuals, foreign exchange, imports, exports etc. are affected by the interest rates. An increase in interest rates may decrease the investment, decrease the consumption, and affect the exchange rates and finally may influence the GDP of the nation. However, the effect of the interest rate on consumption behaviour has been a subject to controversy.
Gross domestic product (GDP), measure of development of the economy, is composed of different factors of the economy such as consumption, investment, government expenditure, import and export. GDP is often correlated with the standard of living. Among these factors, normally consumption occupies a largest chunk. So a change in consumption directly affects the GDP. So, the interest rates, consumption and the GDP are interrelated. Thus, I intend to demonstrate the correlation between ‘interest rates and consumption’ and ‘interest rates and GDP’ of the United Kingdom, in short run, through this dissertation.
* To identify the correlation between interest rates and consumption in the United Kingdom. * To identify the correlation between interest rates and GDP of the United Kingdom.
* To find the relationship between interest rates and exchange rates. * To find the affect of interest rates on public spending. * To find the affect of interest rates on investment.
* To identify affect of interest rates on imports and exports. Research Questions:
* What is the composition of GDP?
* How interest rates and exchange rates are related?
* How exchange rates, import and export are related?
How interest rates and consumptions are related?
What is the effect of change in interest rates to the private investment? *
What in the difference between long run and short run effects in economy? *
How interest rates, consumption and GDP are correlated?
Many economists have put forward their findings about the relationship between interest rate and consumption. But, the effect caused by the interest rate on consumption strategies has been a matter of controversy. Before Keynes (1936), many economists considered the interest to be the important factor to determine the propensity of saving. Keynes introduced ‘Absolute Income Hypothesis’ (AIH) in 1936 which demonstrated that fluctuations in the short run interest rate had no significant effect on spending decisions; rather the consumption behaviour is entirely dependent on current income. The theory asserts that as income rises, the consumption will also rise. However, the increase in consumption may not necessarily follow the same rate of increase in income. Kuznets (1946) reported that the saving rate was not a function of current income. Since the saving ratio remained stable over long range of time. Unlike Keynes, in Modigliani’s (1953) ‘Life Cycle Hypothesis’ (LCH), he assumes that the interest rate plays an influential role in consumption behaviour. According to LCH that individuals consume a constant fraction of the present value of their life time income. The life-cycle model also predicts that individuals save some fraction of their income, while they work, in order to finance their consumption after they retire.
In 1957, an American economist Milton Friedman developed a theory called ‘Permanent Income Hypothesis’ (PIH). This theory explains the consumption...
References: 1. Greet Bekaert and Robert J. H. (2009) “International Financial Management”. Pearson Education.
2. John Maynard Keynes (2008) “The General Theory of Employment, Interest and Money”. BN Publishing.
3. John Sloman and Peter Smith (2006) “ECONOMICS STUDENTS HANDBOOK”. 6th ed. Pearson Education Ltd.
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